SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period EndedJune 30, 2004
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark whether the Registrant is an accelerated filer. Yes X No As of August 1, 2004, there were 73,628,730 shares of the Registrant's Common Stock outstanding, excluding 9,953,392 shares owned by a subsidiary.
TABLE OF CONTENTS
Page
AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
FINANCIAL INFORMATION
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars In Thousands)
June 30,
December 31,
2004
2003
Assets:
Cash and short-term investments
$ 594,736
$ 593,552
Investments:
Fixed maturities:
Available for sale - at market
(amortized cost - $12,730,786 and $11,724,181)
12,843,386
12,101,981
Trading - at market
248,486
195,390
Other stocks - at market
(cost - $316,581 and $258,466)
561,781
454,866
Policy loans
246,027
215,571
Real estate and other investments
283,479
266,435
Total cash and investments
14,777,895
13,827,795
Recoverables from reinsurers and prepaid
reinsurance premiums
3,092,937
3,131,775
Agents' balances and premiums receivable
589,423
502,458
Deferred acquisition costs
1,000,278
851,199
Other receivables
252,022
320,517
Investments of managed investment entity
397,301
424,669
Variable annuity assets (separate accounts)
587,715
568,434
Prepaid expenses, deferred charges and other assets
408,266
402,081
Goodwill
170,026
168,330
$21,275,863
$20,197,258
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 4,871,274
$ 4,909,109
Unearned premiums
1,709,065
1,594,839
Annuity benefits accumulated
7,919,665
6,974,629
Life, accident and health reserves
1,058,208
1,018,861
Payable to reinsurers
381,091
408,518
Long-term debt:
Holding company
684,870
574,618
Subsidiaries
346,480
262,244
Payable to subsidiary trusts (issuers of preferred
securities)
77,800
265,472
Debt of managed investment entity
377,220
406,547
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
982,318
950,267
Total liabilities
18,995,706
17,933,538
Minority interest
186,016
187,559
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 73,446,865 and 73,056,085 shares outstanding
73,447
73,056
Capital surplus
1,045,049
1,035,784
Retained earnings
775,545
664,721
Unrealized gain on marketable securities, net
200,100
302,600
Total shareholders' equity
2,094,141
2,076,161
2
CONSOLIDATED STATEMENT OF EARNINGS
(In Thousands, Except Per Share Data)
Three months ended
Six months ended
Income:
Property and casualty insurance premiums
$529,520
$412,500
$1,016,321
$ 955,285
Life, accident and health premiums
87,553
83,218
177,878
162,728
Investment income
195,895
187,244
387,982
389,123
Realized gains (losses) on:
Securities
687
17,556
36,903
19,289
Subsidiary
-
7,704
(31,682)
Revenues of managed investment entity
4,546
9,437
Other income
83,212
68,385
147,185
121,786
901,413
776,607
1,775,706
1,616,529
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
338,144
317,336
647,774
688,248
Commissions and other underwriting
expenses
161,781
123,796
308,778
280,187
Annuity benefits
73,765
80,860
146,031
155,707
Life, accident and health benefits
65,905
59,307
135,219
122,403
Annuity and life acquisition expenses
32,699
33,271
62,853
59,569
Interest charges on borrowed money
18,097
14,934
35,185
27,982
Interest on subsidiary trust obligations
1,545
6,006
Expenses of managed investment entity
3,146
6,528
Other operating and general expenses
113,661
97,399
216,394
195,249
808,743
726,903
1,564,768
1,529,345
Operating earnings before income taxes
92,670
49,704
210,938
87,184
Provision for income taxes
29,260
13,727
66,642
19,361
Net operating earnings
63,410
35,977
144,296
67,823
Minority interest expense, net of tax
(6,160)
(8,461)
(11,664)
(16,043)
Equity in net earnings (losses)
of investees, net of tax
(882
2,417
(1,800
2,974
Earnings from continuing operations
56,368
29,933
130,832
54,754
Discontinued operations
(428)
577
145
876
Cumulative effect of accounting change
(1,837
Net Earnings
$ 55,940
$ 30,510
$ 129,140
$ 55,630
Basic earnings per Common Share:
Continuing operations
$.77
$.43
$1.79
$.79
(.01)
.01
(.03
Net earnings available to Common Shares
$.76
$.44
$1.76
$.80
Diluted earnings per Common Share:
$1.75
(.02
$.75
$1.73
Average number of Common Shares:
Basic
73,388
69,579
73,280
69,435
Diluted
74,671
69,925
74,509
69,665
Cash dividends per Common Share
$.125
$.25
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in Thousands)
Common Stock
Unrealized
Common
and Capital
Retained
Gain on
Shares
Surplus
Earnings
Total
Balance at January 1, 2004
73,056,085
$1,108,840
$664,721
$302,600
$2,076,161
Net earnings
129,140
Change in unrealized
(102,500)
(102,500
Comprehensive income
26,640
Dividends on Common Stock
(18,303)
Shares issued:
Exercise of stock options
250,499
5,986
Dividend reinvestment plan
5,170
140
Employee stock purchase plan
14,506
425
Retirement plan contributions
76,274
2,269
Deferred compensation distributions
33,620
959
Directors fees paid in stock
11,666
339
Shares tendered in option exercises
(955)
(15)
(13)
(28)
Other
(447
Balance at June 30, 2004
73,446,865
$1,118,496
$775,545
$200,100
$2,094,141
Balance at January 1, 2003
69,129,352
$ 992,171
$409,777
$323,900
$1,725,848
55,630
102,400
158,030
(17,333)
11,000
233
152,870
3,140
24,072
510
313,334
6,219
3,300
71
2,274
48
Shares acquired and retired
(4)
(2,541
Balance at June 30, 2003
69,636,198
$ 999,851
$448,074
$426,300
$1,874,225
4
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Operating Activities:
Adjustments:
1,837
Equity in net (earnings) losses of investees
1,800
(2,974)
11,664
5,898
Depreciation and amortization
89,116
93,539
Realized (gains) losses on investing activities
(45,308)
6,783
Net purchases/sales of trading securities
(58,734)
301
Deferred annuity and life policy acquisition costs
(63,616)
(82,239)
Decrease (increase) in reinsurance and
other receivables
135,491
(246,934)
Decrease in other assets
30,221
36,523
Increase in insurance claims and reserves
117,782
369,408
Decrease in payable to reinsurers
(27,427)
(22,781)
Decrease in other liabilities
(4,260)
(22,389)
Other, net
4,503
4,337
468,240
350,809
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(3,021,929)
(3,549,798)
Equity securities
(73,185)
(24,562)
(10,382)
Real estate, property and equipment
(12,192)
(14,088)
Maturities and redemptions of fixed maturity
investments
694,147
949,402
Sales of:
1,940,941
2,093,884
31,055
15,322
247,380
9,562
7,433
Cash and short-term investments of businesses
acquired or sold, net
27,857
(112,666)
Decrease (increase) in other investments
(22,291
4,349
(436,417
(383,344
Financing Activities
Fixed annuity receipts
340,259
440,769
Annuity surrenders, benefits and withdrawals
(353,921)
(282,890)
Net transfers from (to) variable annuity assets
(3,766)
6,747
Additional long-term borrowings
195,007
220,715
Reductions of long-term debt
(7,897)
(328,180)
Issuances of trust preferred securities
33,943
Repurchases of trust preferred securities
(188,961)
Issuances of Common Stock
5,830
666
Cash dividends paid on Common Stock
(18,163)
(14,193)
973
1,562
(30,639
79,139
Net Increase in Cash and Short-term Investments
1,184
46,604
Cash and short-term investments at beginning
of period
593,552
871,103
Cash and short-term investments at end of period
$ 917,707
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
H.
B.
I.
C.
J.
D.
K.
E.
F.
L.
G.
________________________________________________________________________________
Basis of Presentation
Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Subsidiary Realignment
Investments
current mortgage loan rates and the structure of the security. Other factors affecting prepayments include the size, type and age of underlying mortgages,
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
the geographic location of the mortgaged properties and the creditworthiness of the borrowers. Variations from anticipated prepayments will affect the life and yield of these securities.
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings (included in realized gains) and the cost basis of that investment is reduced.
Derivatives
The terms of the interest rate swaps match those of the hedged debt; therefore, the swaps are considered to be (and are accounted for as) 100% effective fair value hedges. Both the swaps and the hedged debt are adjusted for changes in fair value by offsetting amounts. Accordingly, since the swaps are included with long-term debt in the Balance Sheet, the only effect on AFG's financial statements is that the interest expense on the hedged debt is recorded based on the variable rate.
Managed Investment Entity
Insurance
7
Reinsurance
Subsidiaries of Great American Financial Resources, Inc. ("GAFRI"), an82%-owned subsidiary, cede life insurance policies to a third party on a funds withheld basis whereby GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance (including realized gains and losses) of the retained assets. Effective October 1, 2003, GAFRI implemented SFAS No. 133 Implementation Issue B36 ("B36"). Under B36, these reinsurance contracts are considered to contain embedded derivatives (that must be marked to market) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. As permitted under B36, GAFRI reclassified the securities related to these transactions from "available for sale" to "trading". The mark to market on the embedded derivatives offsets the investment income recorded on the mark to market of the related trading portfolios.
Deferred Policy Acquisition Costs ("DPAC")
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of expected gross profits on the policies. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in "Unrealized gain on marketable securities, net" in the shareholders' equity section of the Balance Sheet.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC includes the present value of future profits on business in force of insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
8
Annuity and Life Acquisition Expenses
Unpaid Losses and Loss Adjustment Expenses
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. In spite of the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated
Life, Accident and Health Reserves
Variable Annuity Assets and Liabilities
Premium Recognition
9
Policyholder Dividends
Payable to Subsidiary Trusts (Issuers of Preferred Securities)
Minority Interest
Income Taxes
Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized.
Stock-Based Compensation
The following table illustrates the effect on net earnings (in thousands) and earnings per share had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method prescribed by
10
SFAS No. 123. For SFAS No. 123 purposes, the "fair value" of $8.92 per option granted in the first six months of 2004 and $5.62 in the first six months of 2003 was calculated using the Black-Scholes option pricing model and the following assumptions: expected dividend yield of 2%; expected volatility of 29% in 2004 and 30% in 2003; risk-free interest rate of 3.7% for 2004 and 3.6% for 2003; and expected option life of 7.5 years in 2004 and 7.4 years in 2003. There is no single reliable method to determine the actual value of options at grant date. Accordingly, actual value of the option grants may be higher or lower than the SFAS No. 123 "fair value".
Net earnings, as reported
$55,940
$30,510
$129,140
$55,630
Pro forma stock option expense,
net of tax
(2,143
(1,605
(3,360
(3,125
Adjusted net earnings
$53,797
$28,905
$125,780
$52,505
Earnings per share (as reported):
$0.76
$0.44
$0.80
$0.75
Earnings per share (adjusted):
$0.73
$0.42
$1.72
$1.70
Benefit Plans
AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.
Discontinued Operations
Earnings Per Share
11
Statement of Cash Flows
National Health Annuity Business
Fidelity Excess and Surplus Insurance Company
Direct automobile insurance business
Infinity Property and Casualty Corporation
Since AFG disposed of substantially all of its Personal insurance business in 2003, it has revised its reporting of the Specialty insurance business into the following components: (i) Property and Transportation which includes inland and ocean marine, agricultural-related business and commercial automobile, (ii) Specialty Casualty which includes executive and professional liability, umbrella and excess liability and excess and surplus, (iii) Specialty Financial which includes fidelity and surety bonds and collateral protection and (iv) California Workers' Compensation. AFG's annuity, supplemental insurance and life business markets primarily retirement annuities and various forms of supplemental insurance and life products. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
12
The following tables (in thousands) show AFG's revenues and operating profit (loss) by significant business segment and sub-segment. Operating profit (loss) represents total revenues less operating expenses.
Revenues (a)
Premiums earned:
Specialty
Property and transportation
$144,942
$ 86,600
$ 269,858
$ 218,794
Specialty casualty
181,014
160,477
355,508
316,077
Specialty financial
99,488
61,965
183,850
121,199
California workers' compensation
82,798
62,238
160,227
121,024
17,180
20,178
37,797
42,212
Personal (b)
21,043
135,981
Other lines
4,098
(1
9,081
(2
529,520
412,500
1,016,321
955,285
63,702
59,345
127,427
129,544
Realized gains
3,958
27,791
29,953
43,027
51,070
43,311
93,675
76,259
648,250
542,947
1,267,376
1,204,115
Annuities, life and health (c)
243,777
228,603
490,789
449,549
Other (d)
9,386
5,057
17,541
(37,135
$901,413
$776,607
$1,775,706
$1,616,529
Operating Profit (Loss)
Underwriting:
$ 22,216
$ 29,181
$ 42,875
$ 34,423
877
760
11,670
(468)
(1,506)
(8,311)
(2,260)
(14,010)
8,333
(302)
12,072
4,415
1,934
(4,155)
118
2,334
Personal (e)
(1,432)
3,780
Other lines (f)
(2,259
(44,373
(4,706
(43,624
29,595
(28,632)
59,769
(13,150)
Investment and other income
60,940
81,939
141,888
151,667
90,535
53,307
201,657
138,517
Annuities, life and health
22,733
13,241
51,820
28,804
(20,598
(16,844
(42,539
(80,137
$ 92,670
$ 49,704
$ 210,938
$ 87,184
(a) Revenues include sales of products and services as well as other income
earned by the respective segments.
(b) There is no earned premium for the Personal group in 2004 due to the sale of Infinity and the direct auto business during 2003, and the transfer, beginning in 2004, of the remaining former Personal business to Specialty transportation (2004 premium of $6 million and $13 million) and Other lines (2004 premium of $4 million and $9 million).
(c) Investment income and realized gains comprise approximately 53% of these
revenues and premiums represent about 36%.
(d) Other revenues and operating profit (loss) for 2003 include the first quarter
loss on the public offering of Infinity. Operating profit (loss) includes
holding company expenses.
(e) There is no underwriting profit for the Personal group in 2004 due to the sale of Infinity and the direct auto business during 2003, and the transfer, beginning in 2004, of the remaining former Personal business to Specialty transportation (2004 profit of zero and $1 million) and Other lines (2004 profit of $1 million for the quarter and six month period).
(f) Represents development of lines in "run-off" and includes a 2003 second
quarter pretax charge of $43.8 million for an arbitration decision relating
to a 1995 property claim from a discontinued business; AFG has ceased
underwriting new business in these operations.
13
Upon formation in 1999, the CDO issued securities in various senior and subordinate classes and the proceeds were invested in primarily floating rate, secured bank loans, and to a lesser extent, high yield bonds, all of which serve as collateral for the securities issued by the CDO. None of the collateral was purchased from AFG. Income from the CDO's investments is used to service its debt and pay other operating expenses, including management fees to AFG. AFG's investment in this CDO is subordinate to the senior classes (approximately 92% of the total securities) issued by the CDO. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, AFG's class would bear losses first.
The assets (substantially all investments carried at market as "trading securities") of this managed investment entity are separately disclosed in the Balance Sheet because they are not available for use to satisfy AFG obligations. Likewise, the CDO liabilities (substantially all debt) are separately disclosed because they represent claims against only the CDO's assets and not against AFG's other assets. Accordingly, AFG's exposure to loss on this investment is limited to its investment (carrying value of $11.9 million at June 30, 2004).
Beginning in 2004, the operating results of the CDO are included in AFG's Statement of Earnings. However, due to the non-recourse nature of the instruments issued by the CDO, any excess losses included in AFG's results that are not absorbed by AFG's investment over the life of the CDO will ultimately reverse when the CDO is liquidated. Accordingly, while implementation of FIN 46 impacts the timing of income recognition, it does not impact the overall amount of income recognized over the life of this investment.
AFG is the investment manager and has an investment with a carrying value of $5.9 million in another CDO (included in fixed maturities) at June 30, 2004, which is not required to be consolidated. This CDO was formed in 2000 and had approximately $475 million in investments at June 30, 2004. In July 2004, AFG invested $4.7 million in a new CDO of which AFG is the investment manager and which AFG will not be required to consolidate.
14
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$296,736
$301,501
AFG Senior Convertible Notes due June 2033
189,857
AFG 7-1/8% Senior Debentures due February 2034
115,000
AFG 7-1/8% Senior Debentures due December 2007
75,100
8,177
8,160
$684,870
$574,618
GAFRI 7-1/2% Senior Debentures due November 2033
$112,500
GAFRI 6-7/8% Senior Notes due June 2008
100,000
GAFRI 7-1/4% Senior Debentures due January 2034
86,250
Notes payable secured by real estate
26,773
27,063
APU 10-7/8% Subordinated Notes due May 2011
10,334
11,433
10,623
11,248
$346,480
$262,244
At June 30, 2004, sinking fund and other scheduled principal payments on debt for the balance of 2004 and the subsequent five years were as follows (in millions):
Holding
Company
$ -
$ 1.0
2005
11.4
2006
19.4
2007
80.4
.1
80.5
2008
100.1
2009
298.0
298.1
In the first quarter of 2004, AFG issued $115 million principal amount of 7-1/8% senior debentures due 2034 and GAFRI issued $86.3 million principal amount of7-1/4% senior debentures due 2034. Proceeds from both offerings were used primarily to redeem at face value a portion of their outstanding trust preferred securities.
GAFRI has entered into interest rate swaps which effectively convert its 6-7/8% Senior Notes to a floating rate of 3-month LIBOR plus 2.9%.
AFG's Senior Convertible Notes were issued at a price of 37.153% of the principal amount due at maturity. Interest is payable semiannually at a rate of 4% of issue price per year through June 2008, after which, interest at 4% annually will be accrued and added to the carrying value of the Notes. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at accreted value ranging from $371.53 per Note at June 2, 2008 to $1,000 per Note at maturity. Generally, holders may convert each Note into 11.5016 shares of AFG Common Stock (at $32.30 per share currently) (i) if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value ($38.76 per share currently), (ii) if the credit rating of the Notes is significantly lowered, or (iii) if AFG calls the notes for redemption.
AFG may borrow up to $280 million under its credit agreement. The line consists of two facilities: a 364-day revolving facility, extendable annually, for one-third of the total line and a revolving facility for the remaining two-thirds with
15
a maturity in November 2005. Amounts borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. In addition, GAFRI has an unsecured credit agreement under which it can borrow up to $155 million at floating rates based on prime or Eurodollar rates through December 2004. GAFRI expects to replace its existing credit agreement with a $150 million, four-year credit facility in the third quarter of 2004.
In accordance with FIN 46, variable interest entities that issued preferred securities subsequent to January 31, 2003, are not consolidated for reporting purposes. Beginning December 31, 2003, previously consolidated subsidiary trusts were deconsolidated for reporting purposes under FIN 46. Accordingly, the subordinated debt due the trusts is shown as a liability in AFG's Balance Sheet. The preferred securities supported by the payable to subsidiary trusts consisted of the following (in thousands):
Date of
Amount Outstanding
Optional
Issuance
Issue (Maturity Date)
6/30/04
12/31/03
Redemption Dates
October 1996
AFG 9-1/8% TOPrS (2026)
$95,459
Redeemed March 2004
November 1996
GAFRI 9-1/4% TOPrS (2026)
65,013
March 1997
GAFRI 8-7/8% Pfd (2027)
42,800
70,000
On or after 3/1/2007
May 2003
GAFRI 7.35% Pfd (2033)
20,000
On or after 5/15/2008
Variable Rate Pfd (2033)
15,000
On or after 5/23/2008
In 2003, a GAFRI subsidiary and a 68%-owned subsidiary of GAI issued an aggregate of $35 million in trust preferred securities maturing in 2033.
The AFG 9-1/8% trust preferred securities and the GAFRI 9-1/4% trust preferred securities were redeemed at face value in March 2004. In addition, during the first quarter of 2004, GAFRI repurchased $27.2 million of its 8-7/8% preferred securities for $28.5 million in cash.
Subsidiaries' common stock
$179,159
$180,937
Managed investment entity
6,857
6,622
$186,016
$187,559
Minority Interest Expense
Interest of noncontrolling investors in earnings of:
$10,452
$ 5,898
1,212
Accrued distributions by consolidated
subsidiaries on preferred securities:
Trust issued securities, net of tax
7,259
AFC preferred stock
2,886
$11,664
$16,043
16
AFG is authorized to issue 12.5 million shares of Voting Preferred Stock and 12.5 million shares of Nonvoting Preferred Stock, each without par value.
The Senior Convertible Notes due in 2033 could be converted under certain conditions into 5.9 million shares of AFG Common Stock.
Stock Options
Included in equity in net earnings of investees for the second quarter and first six months of 2003 was $3.1 million and $4.5 million, respectively, representing AFG's equity in net earnings from Infinity after the date of the initial sale of 61% of Infinity in mid-February 2003.
17
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
18
Results of Operations
25
Overview
General
Critical Accounting Policies
19
Income Items
Liquidity and Capital Resources
Expense Items
28
Ratios
Other Items
30
Sources of Funds
20
Proposed Accounting Standards
21
Uncertainties
23
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of forward-looking words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Examples of such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate increases; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. AFG assumes no obligation to publicly update any forward-looking statements.
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings,
of Financial Condition and Results of Operations - Continued
shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, since most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
In the first quarter of 2004, AFG and GAFRI issued just over $200 million in senior debentures and used approximately $189 million of the proceeds to retire higher coupon debt due unconsolidated subsidiary trusts that, in turn, retired preferred securities.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance and in the sale of retirement annuities and supplemental insurance and life products. With the sale of Infinity in 2003, AFG narrowed the focus of its property and casualty business to its specialized commercial products for businesses.
AFG's net earnings for the 2004 second quarter were $55.9 million or $.75 per share, significantly above the $30.5 million or $.44 per share reported for the second quarter of last year. The increase reflects (i) a 2003 charge for an arbitration decision in the property and casualty group, (ii) 2003 charges related to lower interest rates in the fixed annuity business, and (iii) improved earnings in the insurance operations. These items were partly offset by lower realized gains on investments.
Net earnings for the first six months of 2004 were $129.1 million or $1.73 per share, compared to $55.6 million or $.80 per share recorded in the comparable period in 2003. The improvement results from higher earnings from insurance operations, the 2003 second quarter charges and net realized gains on investments versus net realized losses in the 2003 period.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. Management believes that the establishment of insurance reserves, especially asbestos and environmental-related reserves, and the determination of "other than temporary" impairment on investments are the two areas where the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical. For further discussion of these policies, see "Liquidity and Capital Resources - Investments" and "Liquidity and Capital Resources - Uncertainties."
LIQUIDITY AND CAPITAL RESOURCES
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.08 for the six months ended June 30, 2004, and 1.69 for the entire
year of 2003. Excluding annuity benefits, this ratio was 5.29 and 3.71, respectively. Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
Parent Holding Company Liquidity
AFG's bank credit line consists of two facilities: a 364-day revolving facility, extendable annually, for one-third of the total line and a revolving facility for the remaining two-thirds which matures in November 2005. Amounts borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. This credit agreement provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent company. While the credit line provides up to $280 million of availability, there were no borrowings outstanding during the first six months of 2004.
Subsidiary Liquidity
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In GAFRI's annuity business, however, where profitability is largely dependent on earning a "spread" between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on GAFRI's annuity products. With declining rates, GAFRI receives some protection due to the ability to lower crediting rates, subject to guaranteed minimums.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies.
Approximately 94% of the fixed maturities held by AFG at June 30, 2004, were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and noninvestment grade. Management believes that a high quality investment portfolio should generate a stable and predictable investment return.
Individual portfolio securities are sold creating gains or losses as market opportunities exist. Since all of these securities are carried at market value in the balance sheet, there is virtually no effect on liquidity or financial condition upon the sale and ultimate realization of unrealized gains and losses.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at June 30, 2004, is shown in the following table (dollars in millions). Approximately $124 million of available-for-sale "Fixed maturities" and $22 million of "Other stocks" had no unrealized gains or losses at June 30, 2004.
With
Gains
Losses
Available-for-sale Fixed Maturities
Market value of securities
$6,079
$6,640
Amortized cost of securities
$5,784
$6,822
Gross unrealized gain (loss)
$ 295
($ 182)
Market value as % of amortized cost
105%
97%
Number of security positions
1,461
701
Number individually exceeding
$2 million gain or loss
Concentration of gains (losses) by
type or industry (exceeding 5% of
unrealized):
Gas and electric services
$ 40.1
($ 9.7)
Banks, savings and credit institutions
31.9
(12.2)
Mortgage-backed securities
30.9
(90.8)
Telephone communications
19.2
(2.0)
State and municipal
14.0
(13.1)
U.S. government and government agencies
13.7
(18.3)
Percentage rated investment grade
90%
Other Stocks
$ 482
$ 58
Cost of securities
$ 233
$ 62
$ 249
($ 4)
Market value as % of cost
207%
94%
AFG's investment in equity securities of Provident Financial Group, a Cincinnati-based commercial banking and financial services company, represents $212 million of the $249 million in unrealized gains on other stocks at June 30, 2004. As a result of the merger of Provident and National City Corporation on July 1, 2004, AFG received common and preferred shares equivalent to 8.1 million common shares of National City and will record the above-mentioned Provident gain in the third quarter.
The table below sets forth the scheduled maturities of AFG's available-for-sale fixed maturity securities at June 30, 2004, based on their market values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Maturity
One year or less
5%
- %
After one year through five years
31
After five years through ten years
36
After ten years
83
55
45
100
AFG realized aggregate losses of $2.2 million during the first six months of 2004 on $13.5 million in sales of fixed maturity securities (2 issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2003. Market values of both of the issues increased an aggregate of $1.7 million from December 31 to date of sale.
Although AFG had the ability to continue holding these investments, its intent to hold them changed due primarily to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular credit or industry, or to modify asset allocation within the portfolio.
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Market
Aggregate
Value as
% of Cost
Value
Gain (Loss)
Basis
Fixed Maturities at June 30, 2004
Securities with unrealized gains:
Exceeding $500,000 (164 issues)
$1,673
$152
110.0%
Less than $500,000 (1,297 issues)
4,406
143
103.4
$295
105.1%
Securities with unrealized losses:
Exceeding $500,000 (105 issues)
$2,735
($107)
96.2%
Less than $500,000 (596 issues)
3,905
(75
98.1
($182)
97.3%
22
The following table summarizes (dollars in millions) the unrealized loss for all fixed maturity securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
Fixed Maturities with Unrealized
Losses at June 30, 2004
Investment grade with losses for:
One year or less (638 issues)
$6,349
($166)
97.5%
Greater than one year (20 issues)
112
(7
94.1%
$6,461
($173)
97.4%
Non-investment grade with losses for:
One year or less (25 issues)
$ 128
($ 3)
97.7%
Greater than one year (18 issues)
51
(6
89.5%
$ 179
($ 9)
95.2%
When a decline in the value of a specific investment is considered to be "other than temporary," a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced. The determination of whether unrealized losses are "other than temporary" requires judgment based on subjective as well as objective factors. A listing of factors considered and resources used is contained in the discussion of "Investments" under Management's Discussion and Analysis in AFG's 2003 Form 10-K.
Based on its analysis, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
Property and Casualty Insurance Reserves
and other factors, AFG actuaries determine a single or "point" estimate which management utilizes in recording its best estimate of the liabilities. Ranges of loss reserves are not developed by AFG actuaries.
Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors which are subject to significant variation. Through the use of analytical reserve development techniques, management utilizes items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, general economic trends and the legal environment.
While current factors and reasonably likely changes in variable factors are considered in estimating the liability for unpaid losses, there is no method or system which can eliminate the risk of actual ultimate results differing from such estimates. As shown in the reserve development table (loss triangle) on page 11 of AFG's 2003 Form 10-K, the original estimates of AFG's liability for losses and loss adjustment expenses, net of reinsurance, over the past 10 years have developed through December 31, 2003, to be deficient (for three years) by as much as 10.4% and redundant (for 7 years) by as much as 7.2% (excluding the effect of special charges for asbestos and environmental exposures). AFG believes this development illustrates the variability in factors considered in estimating its insurance reserves.
Quarterly reviews of unpaid loss and LAE reserves are prepared using standard actuarial techniques. These may include: Case Incurred Development Method; Paid Development Method; Bornhuetter-Ferguson Method; and Incremental Paid LAE to Paid Loss Methods. Generally, data is segmented by major product or coverage within product using countrywide data; however, in some situations data may be reviewed by state or region.
Asbestos and Environmental-related ("A&E") Reserves
While management believes that AFG's reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims and the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, whether claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims.
24
In February 2003, Great American Insurance Company entered into an agreement for the settlement of asbestos related coverage litigation under insurance polices issued during the 1970's and 1980's to Bigelow-Liptak Corporation and related companies, subsequently known as A.P. Green Industries, Inc. ("A.P. Green"). Management believes that this settlement will enhance financial certainty and provides resolution to litigation that represents AFG's largest known asbestos-related claim and the only such claim that management believes to be material.
The settlement is for $123.5 million (Great American has the option to pay in cash or over time with 5.25% interest), all of which is covered by reserves established prior to 2003, and anticipated reinsurance recoverables for this matter. The agreement allows up to 10% of the settlement to be paid in AFG Common Stock.
The settlement has received the approval of the bankruptcy court supervising the reorganization of A.P. Green. It remains subject to the confirmation by the bankruptcy court of a plan of reorganization that includes an injunction prohibiting the assertion against Great American of any present or future asbestos personal injury claims under policies issued to A.P. Green and related companies. This process should be completed in 2004. No assurance can be made that a plan of reorganization will be confirmed; no payments are required until completion of the process. If there is no plan confirmation, the outcome of this litigation will again be subject to the complexities and uncertainties associated with a Chapter 11 proceeding and asbestos coverage litigation.
RESULTS OF OPERATIONS
Operating earnings before income taxes increased $43 million in the second quarter of 2004 compared to the same period in 2003. The improvement reflects a $44 million charge in 2003 for an arbitration decision relating to a 1995 property claim and, excluding the arbitration charge, a $14 million improvement in property and casualty underwriting results in 2004. In addition, AFG's annuity operations in 2003 included second quarter charges of $12.5 million related to the negative effect of lower interest rates on the fixed annuity business. These items more than offset a $25 million decrease in realized gains.
Six-month pretax operating earnings improved $124 million compared to 2003 reflecting a $49 million increase in realized gains, a $29 million improvement in property and casualty underwriting results, and the 2003 second quarter charges. These items more than offset a $7 million increase in interest expense on borrowed money and the reclassification of interest on subsidiary trust obligations from minority interest.
Property and Casualty Insurance - Underwriting
Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their
financial statements better understand the company's performance. See Note C - "Segments of Operations" for the detail of AFG's operating profit by significant business segment.
Underwriting profitability is measured by the combined ratio which is a sum of the ratios of underwriting losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes.
Premiums and combined ratios for AFG's Specialty property and casualty insurance operations were as follows (dollars in millions):
Gross Written Premiums (GAAP)
Specialty:
$338.2
$287.6
$ 578.1
$ 479.2
388.3
353.8
751.6
693.7
121.2
87.5
227.8
161.7
90.2
68.5
186.4
138.1
(2.2
(1.2
(1.5
.3
Total Specialty
$935.7
$796.2
$1,742.4
$1,473.0
Net Written Premiums (GAAP)
$206.0
$127.7
$ 352.9
$ 252.6
193.8
172.3
392.1
338.0
95.4
70.2
186.0
127.7
80.6
63.3
164.6
129.3
13.1
16.9
30.4
41.6
$588.9
$450.4
$1,126.0
$ 889.2
Combined Ratios (GAAP)
84.6%
66.3%
84.1%
84.3%
99.4
99.5
96.8
101.5
113.4
101.2
111.7
90.0
100.5
92.5
96.3
88.7
120.6
99.7
94.4
94.0%
95.7%
93.6%
96.8%
(a) AFG's aggregate combined ratio, including the former Personal group and other, primarily discontinued, lines was 94.5%, 106.9%, 94.1% and 101.4% in the four periods. The 2003 aggregate ratios include 10.6 points and 4.6 points in the second quarter and six months, for the effect of a $43.8 million charge for an arbitration decision relating to a claim arising from a discontinued business.
26
The Specialty group reported an underwriting profit of $31.9 and $64.5 million for the second quarter and first six months of 2004. The combined ratios for these respective periods improved 1.7 and 3.2 points over the comparable 2003 periods as a result of rate increases and less prior year adverse development in 2004.
Property and transportation gross written premiums increased 18% and 21% during the second quarter and first six months of 2004 reflecting primarily volume increases in the crop, equine, truck, bus and recreational vehicle products, and to a lesser extent, rate increases. Net written premiums increased 61% and 40%, primarily reflecting the items above plus a reduction in ceded reinsurance premiums in 2004 for the inland marine, crop and truck divisions. The abnormally low combined ratio for the second quarter of 2003 was due primarily to the effect of a quota share reinsurance agreement and some favorable reserve development.
Specialty casualty net written premiums increased 12% in the second quarter and 16% for the first six months compared to the same periods in 2003. The increase for the quarter is primarily a result of rate increases while the six month increase also reflects the return of premium as a result of the cancellation of certain reinsurance agreements. The 3.3 point improvement in the combined ratio for the first six months of 2004 reflects a favorable change in prior year development and the impact of rate increases. Though the combined ratios for the second quarters of 2004 and 2003 were similar, both periods included significant amounts of adverse prior year development, including $20 million in 2004 within the executive liability operations.
Specialty financial gross written premiums increased 39% during the second quarter and 41% for the first six months of 2004 reflecting substantial volume growth in collateral protection products for financial institutions. The combined ratio for Specialty financial improved 11.9 and 10.5 points in the second quarter and first six months of 2004, reflecting significant growth in the more profitable collateral protection products sold to financial institutions.
California workers' compensation net written premiums grew 27% for both the second quarter and first six months of 2004 reflecting modest rate increases and an increase in volume. The combined ratio improved 10.5 and 3.8 points for the second quarter and first six months of 2004 compared to the same periods in 2003. The improvement in the results reflects the impact of rate increases and adverse prior year development recorded in the second quarter of 2003.
27
Investment Income
Realized Gains
Gains (Losses) on Securities
Gains (Losses) on Sales of Subsidiaries
Real Estate Operations
$28.8
$26.4
$45.8
$42.4
20.1
18.7
36.2
34.8
.5
.7
1.0
1.3
Minority interest expense, net
.9
.2
Other income includes net pretax gains on the sale of real estate assets of $4.9 million in the second quarter and $6.5 million for the first six months of 2004 compared to $4.7 million for the 2003 periods.
Other Income
Annuity Benefits
On its deferred annuities (annuities in the accumulation phase), GAFRI generally credits interest to policyholders' accounts at their current stated interest rates. Furthermore, for "two-tier" deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), GAFRI accrues an additional liability to provide for expected deaths and annuitizations. Changes in crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect this accrual.
The majority of GAFRI's fixed annuity products permit GAFRI to change the crediting rate at any time subject to minimum interest rate guarantees (as determined by applicable law). Approximately half of the annuity benefits accumulated relate to policies that have a minimum guarantee of 3%; the majority of the balance has a guarantee of 4%. Beginning in the fourth quarter of 2003, in states where required approvals have been received, GAFRI began issuing products with guaranteed minimum crediting rates of less than 3%.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Continued spread compression, decreases in the stock market and adverse mortality could lead to write-offs of DPAC in the future.
Interest on Borrowed Money
Interest on Subsidiary Trust Obligations
29
Other Operating and General Expenses
Investee Corporations
Start-up Manufacturing Business
Cumulative Effect of Accounting Change
Equity Compensation
Investments in Limited Liability Companies
Convertible Notes
______________________________________________________
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
Debt Securities
As of June 30, 2004, there were no other material changes to the information provided in AFG's Form 10-K for 2003 under the caption "Exposure to Market Risk" in Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 4
Controls and Procedures
AFG's management, with participation of its Chief Executive Officer and Chief Financial Officer, has evaluated AFG's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG's CEO and CFO concluded that the controls and procedures are effective. There have been no significant changes in AFG's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
PART II
OTHER INFORMATION
Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Under AFG's shareholder-approved Stock Option Plan, 955 shares of AFG Common Stock (fair value of $29.24 per share) were tendered to exercise stock options for 1,000 shares in May 2004.
Great American Financial Resources, Inc., an 82%-owned subsidiary of AFG, repurchased 10,600 shares of their common stock in May 2004.
Submission of Matters to a Vote of Security Holders
AFG's Annual Meeting of Shareholders was held on May 25, 2004; there were four matters voted upon: (Item 1) election of nine directors, (Item 2) approval ofNon-employee Directors Compensation Plan, (Item 3) ratifying Ernst & Young as independent public accountant and (Item 4) shareholder proposal to expense stock options.
The votes cast for, against, withheld and the number of abstentions and brokernon-votes as to each matter voted on at the 2004 Annual Meeting is set forth below:
Broker
Name
For
Against
Withheld
Abstain
Non-Votes
Item 1
Theodore H. Emmerich
64,385,562
N/A
1,118,168
James E. Evans
63,520,090
1,983,640
Terry S. Jacobs
64,845,806
657,924
Carl H. Lindner
64,196,273
1,307,457
Carl H. Lindner III
64,347,794
1,155,936
S. Craig Lindner
64,349,016
1,154,714
William R. Martin
64,838,953
664,777
William A. Shutzer
63,987,123
1,516,607
William W. Verity
63,979,591
1,524,139
Item 2
58,781,525
2,915,091
75,428
3,731,686
Item 3
64,897,017
565,573
41,140
Item 4
14,947,537
46,364,058
460,449
N/A - Not Applicable
32
OTHER INFORMATION - CONTINUED
ITEM 6
Exhibits and Reports on Form 8-K
(a) Exhibits:
Number
Exhibit Description
Computation of ratios of earnings to fixed charges.
Certification of the Chief Executive Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
Certification of the Chief Executive Officer and Chief
Financial Officer pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
(b) Reports furnished on Form 8-K:
Date of Report
Item Reported
April 26, 2004
First Quarter 2004 Earnings Release.
July 21, 2004
Second Quarter 2004 Earnings Release.
_________________________________________________
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned duly authorized.
American Financial Group, Inc.
August 5, 2004
BY: s/Fred J. Runk
Fred J. Runk
Senior Vice President and Treasurer
33